Thoughts

December 16, 2022 | 13:39

2023 Canada Rates Preview: The Year of Living Steadily (Mostly)

Economist

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

It’s going to be hard to top the excitement of 2022, with the Bank of Canada delivering 400 bps of rate hikes, the most in any calendar year on record. Following that aggressive policy path, policymakers have made it clear that the bias for rates remains higher, but that any future hikes will be entirely data dependent.

Our base case is for one more 25 bp hike in the early part of 2023. We have January pencilled in at the moment, but that could change if the two inflation prints ahead of the January meeting are on the soft side. Beyond Q1, we expect the Bank of Canada to hold policy rates at 4.50% through the balance of the year as inflation only slowly decelerates. We are anticipating a recession in 2023 (even if the timing is somewhat uncertain), which, combined with a steady deceleration in underlying inflation, should lay the groundwork for potential rate cuts in 2024.

The risks to our base case are skewed to higher rates. Inflation forecasts were nowhere near high enough in 2022, and there’s no reason to believe they’ll be materially better in 2023. There’s more risk of a high-side surprise. We’re not anticipating another war-driven spike in oil prices, but the economy’s resilience thus far in the face of the most aggressive rate hike campaign in a generation hints at potentially stickier inflation pressure. Wage growth is near record highs (excluding pandemic distortions), and the labour market hasn’t shown any consistent sign of cooling yet. Job vacancies are down slightly but remain elevated, while weak labour force growth through the back half of this past year meant that decelerating job growth hasn’t pushed the unemployment rate higher.

On the flip side, the recent sharp decline in oil prices could ripple through to other prices, pulling inflation down faster. However, the stimulative impact of lower gasoline prices could make the economy more resilient and could drive stickier services inflation pressure. Accordingly, policymakers will be focused entirely on core inflation metrics through at least the early part of the year.

The evolution of the Canadian dollar and interest rates will feed into BoC decision-making as well. The loonie was a middling performer in 2022, losing ground in Q4 after outperforming through most of the year. With the Fed expected to slow its tightening pace and eventually pause next year, we anticipate that the US$ will be weaker at this time next year. Accordingly, we have the C$ ending 2023 at C$1.30. On the interest rate front, the rally in recent weeks has brought bond yields down sharply. Unless we get continued encouraging readings on CPI, look for some back up early in the new year. However, by the end of 2023, we have 10-year GoC rates back around current levels.

Key Takeaway: Expect steady-to-higher policy rates in 2023, with bond yields taking a round trip up and down. The loonie looks to benefit from a softer US$, but gain little ground versus other major currencies.